What Are Interest Rates and Why Should You Care?

Whenever you apply for financing for an item that you aren’t paying for upfront, you agree to pay interest to the institution that’s lending you the money. But what are interest rates — and how do they affect you? Knowing the answer to this question will help you figure out what interest rates you might qualify for and how you can use them to your advantage.

Simply put, interest rates are the percentage of the principal, or loan amount, that a lender charges you in exchange for your use of its funds. Banks use the deposits that other people make to their checking and savings accounts to fund the loans – and in return, you earn interest on the money you place in your own savings account.

Interest rates can have enormous trickle-down effects on the entire United States economy and your own financial life. America’s central bank, the Federal Reserve, adjusts interest rates to promote long-term economic balance. In 2019 alone, the Fed slashed rates three times in a bid to protect the slowing economy.

To fully understand how interest rates work and their impact on your everyday life, check out this comprehensive guide to interest rates.

How Interest Rates Work

Whenever you borrow money from a lender or credit card company for a purchase, they charge you a fee for the cost of using those funds. For example, if you borrow $1,000 at an annual interest rate of 2%, the total cost of the purchase would be $1,020. However, you can also avoid paying interest when you pay off a balance in full each month on your credit card. Some interest-free financing promotions waive interest if you pay off the principal balance within a certain timeframe, such as 24 months.

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Banks and lenders charge you interest for two reasons — to turn a profit and to shield themselves from risk. If you have a lower credit score, a bank might decide you’re a high default risk, and in return, charge you a higher interest rate. That’s why people with stellar credit scores tend to snag the lowest-interest loan and credit card offers.

Interest rates don’t just cost you money — they can also put free money in your pocket. When you place money in a savings account, the bank will pay you interest based on the size of your deposits. The bank views the funds in your savings account as money that it’s “borrowing” from you.

Besides for your credit history, lenders determine your interest rate based on a few other factors, including:

The type of credit: A secured loan is backed by collateral, which means it poses a lower risk to the lender. For example, if you fail to pay your mortgage, the bank can seize your house. Unsecured credit, such as credit cards and most personal loans, come with much higher interest since the lender has no property to repossess if things go awry.

The length of the loan: If you need a longer period to repay your loan, the interest rate will be higher than a short-term loan. Not only will your borrowing relationship with the lender last longer, but you’re also paying for the additional risk of possible default during the extended life of the loan.

Lenders may hike their long-term interest rates when a borrower requests a longer-term loan. That’s because the dollar amount will decline in value in several years, even in a healthy economy.

What Are Some Common Types of Interest Rates?

The term “interest rate” is rather broad, and doesn’t take into account the differences among various types of interest rates. Here are the most common types of interest rates you’re likely to hear about:

Prime Interest Rate: Banks charge this interest rate for their most creditworthy corporate customers. The prime interest rate is used as a point of reference for other interest rates, including adjustable-rate mortgages, credit cards, and personal loans.

Fed Interest Rate: The interest rate that banks charge other banks for lending them money from their reserve balances on an overnight basis. The Federal Reserve uses its federal funds rate to keep a healthy supply of available funds and to control inflation as well as other economic risks.

Mortgage Rates: Purchasing real estate prompts a whole wave of other interest issues. Typically, you will have either a fixed-rate or adjustable loan. When you take out a fixed-rate loan, the interest rate remains the same throughout the lifetime of the loan. An adjustable-rate mortgage will likely start at a lower interest rate — saving you money upfront — but the rates will fluctuate based on changes in the market.

Annual Percentage Rate: APR describes the interest rate as a yearly amount and includes all other loan-related fees, such as origination and transaction fees. While you might hear the term “interest rates” more frequently, the APR actually takes into account the total amount you’ll pay for the cost of borrowing.

Simple interest: Banks typically use a simple interest formula to calculate the interest on a loan or deposit. Simple interest applies to the principal loan amount. It is generally used for short-term loans or credit card balances.

Compound interest: As opposed to simple interest, compound interest applies to the principal loan amount as well as the interest that has accrued for previous periods. It is typically used for longer-term loans or savings accounts and CDs.

How Does a Fed Funds Rate Hike Affect Interest Rates?

The Federal Reserve is the gatekeeper of America’s interest rates. It raises and lowers the federal funds’ rates in response to ebbs and flows in the economy. The Fed’s Federal Open Market Committee meets eight times a year to discuss the state of the economy. When growth has stalled, and the economy needs a boost, the Fed will lower the fed funds rate. When the economy expands too rapidly, it can trigger inflation, which the Fed keeps in check by raising the Fed funds rate.

Even though the fed funds rate refers to the rate that banks charge other banks for overnight loans, the effect on the broader U.S. economy flows much deeper. Soon after the Fed announces a fed funds hike, banks will typically follow suit and announce similar increases in their prime rates. Prime rate increases then result in higher interest rates on credit cards and home loans. You will also find higher interest rates on savings accounts and CDs.

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In the wake of a fed funds rate hike, the cost of most types of consumer credit will jump, including auto loans, credit cards, home mortgages, and personal loans.

How a Change in Interest Rates Can Impact Your Financial Decisions

Interest rate changes affect every aspect of your financial life, but you’ll notice the difference in new, variable-rate financial products. Here’s what you need to know about interest rate impacts of the most commonly used financial products:

Certificates of Deposit: Your rate is already locked in if you currently have CDs. However, if you intend to purchase a new CD, any rate cuts may lower the interest rate available to you, and a rate hike will increase the interest rate.

Personal loans: If you have a personal loan with a variable rate, you may notice a change in the interest rate. If you have a fixed-rate loan, you won’t see a difference in the interest rate.

Mortgage Loans: When interest rates rise while you are house-shopping, it could affect how much you could afford to pay for a home. Once you own your house, if you have a fixed-rate mortgage, you’ll be in good shape, but your interest rate could rise or fall with an adjustable-rate mortgage.

Student loans: You can capitalize on lower interest rates by refinancing your student loans, which will lower your overall interest and shave a chunk off of your monthly payment. Federal loans do not change since they have fixed rates.

Credit card interest rates: Most credit card interest rates are variable, meaning they change in response to the fluctuations in the central interest rate. However, they can also change at any time–even when other rates are stable.

How Interest Rates Impact the Economy

Interest rates have a tremendous impact — both good and bad — on the broader United States economy, including consumer spending and the state of the stock market. However, keep in mind that each time the Fed changes interest rates, it’ll typically take at least a year for changes to take effect in other areas. These are the main ways interest rates affect the economy:

Inflation: When interest rates sink too low, that can spur excessive purchases that lead to inflation. When the Federal Reserve notices that the economy is inching dangerously close to exceeding their target inflation rate, they reverse the trend by cutting the federal funds rate, which will eventually slow Americans’ spending and cool down the economy.

Recession: In times of recession, such as the financial crisis in 2008, the Fed slashed interest rates to nearly zero to help the economy stabilize. Those rates remained near zero until 2015. That move was intended to encourage consumers to resume spending since borrowing money then became much cheaper.

Stock and Bond Market: Interest rates have a direct effect on the stock and bond market. When interest rates are high, businesses tend to rein in spending, which causes stock prices to drop. Lower interest rates spur more confidence and purchasing, which elevates stock prices. When interest rates rise, bond prices fall, and as rates decrease, bond prices rebound.

How Interest Rates Affect You

Interest rates rise and fall depending on economic growth or slowdown. When you’re tuned in to how the central interest rate guides the rates of other financial products, you can make smarter decisions with your spending, borrowing, and investing.

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About the Author

Andrew Lisa has been writing professionally since 2001. An award-winning writer, Andrew was formerly one of the youngest nationally distributed columnists for the largest newspaper syndicate in the country, the Gannett News Service. He worked as the business section editor for amNewYork, the most widely distributed newspaper in Manhattan, and worked as a copy editor for TheStreet.com, a financial publication in the heart of Wall Street’s investment community in New York City.

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